This morning, I listened to the Annaly Capital Management (NYSE:NLY) earnings call. The mortgage real-estate investment trust (REIT) is down about 4% today, mostly because of the massive narrowing in its interest rate spread. The company saw its interest rate spread decline to 0.90% from 1.43% last quarter, which was partially due to increased costs of capital at 23 basis points and a decline of 30 basis points in its average interest yield on assets due to increased amortization. The latter is simply because the portfolio rallied, and I can't determine the amortization cost as realized pay-up speeds are still very low.

According to management comments on the call, the increased cost of capital is due to an extension in the duration of Annaly's interest rate swap positions. It views the Treasury market as too optimistic -- or, in the case of the economy, pessimistic. With the 10-year US Treasury note one-year forward now at approximately 2.9%, that offers Annaly the ability to extend the duration of its swaps to benefit from any rise in interest rates.

The takeaway is that the contraction in Annaly's interest rate spread isn't all bad. If long rates were to rise during the rest of the year, the REIT will stand to benefit substantially. Judging by the pay rate on Annaly's swaps, it appears that it added $4.5 billion notional in 30-year ($2.8 billion) and 10-year ($1.4 billion) swaps against small reductions in its shorter-dated swap holdings (source: company filing). This would be very accretive for Annaly's book value in the coming quarters should rates rise, but equally negative if rates do not.

The decrease in its earnings yield appeared at first to be from drawing down a position in the portfolio, but new positions were added at 30-year maturities with higher coupons (which fall slower in value as rates rise), and the selling of $5 billion in assets was low relative to the size of the portfolio (which grew) versus the prior quarter.

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